How Much Can You Afford?

HOW MUCH HOUSE CAN YOU AFFORD?

Mortgage lenders are chiefly concerned with your ability to repay the mortgage. To determine if you qualify for a loan, they will consider your credit history, your monthly gross income and how much cash you’ll be able to accumulate for a down payment. So how much house can you afford? To know that, you need to understand a concept called “debt-to-income ratios.”

Debt-to-income ratios

The standard debt-to-income ratios are the housing expense ratio and the total debt-to-income ratio. These are also known as the front-end and back-end ratios, respectively.

The idea of buying your first home can be intoxicating and intimidate at the same time. You are embarking on a journey down an unfamiliar road, so the first consideration is what you can afford to spend on a house.

Front-end ratio

Maximum housing expense ratio = annual salary x 0.28 / 12 (months)

Back-end ratio: The total debt-to-income, or back-end, ratio, shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees. In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your debt-to-income ratio, multiply your annual salary by 0.36, then divide by 12 (months). The answer is your maximum allowable debt-to-income ratio.

Back-end ratio

Example

Take a homebuyer who makes $40,000 a year. The maximum amount for monthly mortgage-related payments at 28 percent of gross income is $933. ($40,000 times 0.28 equals $11,200, and $11,200 divided by 12 months equals $933.33.)

Furthermore, the lender says the total debt payments each month should not exceed 36 percent, which comes to $1,200. ($40,000 times 0.36 equals $14,400, and $14,400 divided by 12 months equals $1,200.)

Consider this from a couple of different angles:

How much of a monthly payment can I afford?

What savings do I have available for a down payment?

How do I plan to cover other expenses such as the earnest money deposit and closing costs?

The rule of thumb for monthly payments is that they shouldn’t exceed 25 to 30 percent of your monthly gross income. Monthly payments include your mortgage principal and interest, real estate taxes, mortgage insurance, and homeowners’ insurance, so be sure to include these if you are running your own numbers. As for down payments, they range from nothing to 20 percent or more, with most buyers falling in between these two extremes.

Here are some other useful percentages: your total housing costs shouldn’t consume more than 32 percent of your gross monthly income. When you’ve been renting, it has been easy to underestimate the ongoing costs involved in homeownership, which range from simple and fairly inexpensive matters such as calling the plumber to unclog your sink to the budget-busting cost of putting on a new roof. And, your total debt load—including car loans, student loans, credit card debt, etc.—shouldn’t exceed 40 percent of your gross monthly income.

So, if you and your spouse have a combined gross income of $50,000 a year, the numbers work out like this:

Monthly payments between $1,041 and $1,250

Total housing expenses not to exceed $1,333

Total debt load not to exceed $1,667

These are important numbers because they are the ones that lenders will come up with when you start asking about getting pre-approved for a mortgage. A mortgage pre-approval means that a lender has checked you out and made a commitment to offer you a mortgage for a certain amount based on your financial situation.